Now is the perfect time to debate the historical and future role of financial markets

'Responsible' investing has been shown to be both practical and often profitable. But the sad truth is that financial markets remain disengaged.

Financial market reform is today's most debated public policy issue. The debate, however, focuses narrowly on securing the resilience of financial markets as we know them. The broader aspects of resilience are being ignored, that of the role of financial markets in ensuring the long-term sustainability of the global economy in the light of natural resource and climate challenges and the destabilising effects of endemic inequality and poverty.

"Finance is a means to an end, not an end in itself", argues Nobel economist Joe Stiglitz. "It is supposed to serve the interests of the rest of society, not the other way around." Yet our economy is unsustainable because our financial markets allocate capital to businesses that are profoundly unsustainable. Their narrow financial focus blended with a myopic short-termism delivers toxic investor behaviour that is preventing our transition to the green economy needed to survive and prosper in the 21st century.

Today's financial crisis and accompanying economic recession is the stimulus we need to realign financial markets, rapidly and at scale, to the needs of a sustainable economy.

Global financial assets were $150tn in 2010, topping pre-recession levels for the first time. Allocating these assets represents our investment in tomorrow's economy, our collective source of livelihood. Over $150bn was invested in 2008 in clean technology projects and companies, a four-fold increase since 2004. While this is encouraging, these numbers bear little relation to the trillions of annual investment needed in green infrastructure.

"Responsible" investing has been shown to be both practical and often profitable. Furthermore, initiatives such as United Nations Environment Programme Finance Initiative (UNEP-FI) and the United Nations Principles of Responsible Investing (UNPRI) highlight the "sign up" to the cause of asset managers worth tens of trillions of dollars. But the sad truth is that financial markets remain disengaged. Survey after survey of fund managers and analysts confirms the marginal status of most aspects of the sustainability agenda. Advocates of sustainable investing are themselves increasingly expressing doubts over its impact on the rump of investment behaviour, all the more so in the face of what many see as a return to "business as usual" following the financial crisis. As one leading sustainability investor argued, "given the scale and pace of change that is desperately needed, we have to conclude that our current approach will not do enough".

There is no magic answer to achieving the much-needed realignment, but there are some well-defined policy pathways that offer considerable potential. Overcoming short-termism is a pre-condition for progress, as sustainability will count for more when investors consider the long-term performance of prospective investments. Andrew Haldane at the Bank of England has offered compelling evidence that investors are increasingly turning away from profitable investment opportunities because of their distorting appetite for short-term profit-taking. Fund managers are perversely incentivised towards short-termism, and this has not got any better as a result of painful lessons from the financial crisis, a point confirmed in a recent study published by leading executive remuneration experts, Mercer Consulting.

Persuasion is of course a route to be taken, one fund manager and one pension-fund trustee at a time. But such gradual, voluntary approaches will not overcome these problematic biases any time soon. Regulatory and fiscal interventions have to be considered. One such proposal has been for a financial transaction tax that reduces the profitability of short-term trading activities. The so-called "Robin Hood tax" advocated for a while by France's President Sarkozy, might have served this purpose, but it was bartered away, at least for now, during the push-and-shove of G20 and European politics. Other policy interventions being tested that might serve to reduce short-termism include bans on naked shorting, penalising taxes on non-resident currency trading, and greater disclosure, for example of how climate change is being factored into investment strategies.

Trustees of our pension funds and other financial assets have a "fiduciary responsibility" to us, the intended beneficiaries. Designed to protect the financial security of private citizens, these responsibilities are in need of a serious overhaul as a growing body of analysis highlights their underperformance by traditional financial performance measures, resulting from competency gaps, perverse incentives, asymmetrical information, unintended consequences of accounting regulations and practices, perceived risk and litigation-driven conservatism, conflicts of interest, and the behavioural effects of the herd mentality.

Here there are options for greater regulatory interventions in asset allocation by institutional investors to take greater account of sustainability factors in investment decisions. South Africa, for example, has been the second country (after the UK) to advance a code for responsible investing, seeking on a voluntary basis to influence the conduct of investors with a strong sustainability focus. China's Shanghai stock exchange has recently followed other major stock exchanges in launching a sustainability index intended to influence the decisions guiding Chinese and international investors with both a strong "tracker" approach and an interest in sustainability as a lead indicator of long-term financial performance.

State funds are a relatively small but rapidly growing segment of the financial markets, including not only high-profile sovereign wealth funds (which alone have total assets approaching $3tn, a sum expected to reach $7tn by 2012), but China's policy banks, the various trade, investment and development promotion investment vehicles scattered all over the world, and a new generation of funds such as the UK's planned green bank. State-owned or controlled investment vehicles have the potential, given the mandate and competencies, to make a huge difference to the approach of the financial markets to sustainability issues. In rare instances, sustainability is an explicit element of a state fund's mandate, such as in the case of the Norwegian fund. More commonly it is the funds' "long term" interests that offers most potential for enhanced alignment to sustainability outcomes. Chinese public and private investors, frankly, are most likely to lead in the coming years in investing in Africa's green economy.

Current financial market reform efforts provide a unique opportunity to advance the insertion of sustainability as a fundamental performance condition. Fiscal interventions, changes in fiduciary responsibility and leveraging the growing power of state-owned funds are but three of the possible policy pathways for doing this in practice. Arguments that it's too soon (our priority must be to prevent meltdown) or that it's too tough, (the difficulties in influencing a sector that can relocate profits with astonishing ease) have only superficial merit. Systemic reforms in the financial markets are undoubtedly needed to unleash their power in favour of a sustainable economy, and such changes will be all the harder once the current reforms have run out of steam and the sector is no longer in the public eye. Now is exactly the right time to mobilise public debate about the historical role of the financial markets, and to advance practical measures for this role to succeed in practice.

Today's financial crisis and accompanying economic recession is the stimulus we need to realign financial markets, rapidly and at scale, to the needs of a sustainable economy.

The opinions expressed in this article/multimedia are those of the author(s) and do not necessarily reflect the views of CIGI or its Board of Directors.

Returnto cigi2017

This site uses cookies to provide the best online experience. By using this site, you agree to the use of cookies and collection of personal information per our Privacy Notice. To alter or disable the use of cookies, adjust your browser settings.